What Is a Non-Performing Asset (NPA)?

A nonperforming asset (NPA) refers to a classification for loans or advances that are in default or in arrears. A loan is in arrears when principal or interest payments are late or missed. A loan is in default when the lender considers the loan agreement to be broken and the debtor is unable to meet his obligations.

Key Takeaways

  • Nonperforming assets (NPAs) are recorded on a bank's balance sheet after a prolonged period of non-payment by the borrower.
  • NPAs place financial burden on the lender; a significant number of NPAs over a period of time may indicate to regulators that the financial health of the bank is in jeopardy.
  • NPAs can be classified as a substandard asset, doubtful asset, or loss asset, depending on the length of time overdue and probability of repayment.
  • Lenders have options to recover their losses, including taking possession of any collateral or selling off the loan at a significant discount to a collection agency.

How Non-Performing Assets (NPA) Work

Nonperforming assets are listed on the balance sheet of a bank or other financial institution. After a prolonged period of non-payment, the lender will force the borrower to liquidate any assets that were pledged as part of the debt agreement. If no assets were pledged, the lender might write-off the asset as a bad debt and then sell it at a discount to a collection agency.

In most cases, debt is classified as nonperforming when loan payments have not been made for a period of 90 days. While 90 days is the standard, the amount of elapsed time may be shorter or longer depending on the terms and conditions of each individual loan. A loan can be classified as a nonperforming asset at any point during the term of the loan or at its maturity.

For example, assume a company with a $10 million loan with interest-only payments of $50,000 per month fails to make a payment for three consecutive months. The lender may be required to categorize the loan as nonperforming to meet regulatory requirements. Alternatively, a loan can also be categorized as nonperforming if a company makes all interest payments but cannot repay the principal at maturity.

Carrying nonperforming assets, also referred to as nonperforming loans, on the balance sheet places significant burden on the lender. The nonpayment of interest or principal reduces the lender's cash flow, which can disrupt budgets and decrease earnings. Loan loss provisions, which are set aside to cover potential losses, reduce the capital available to provide subsequent loans to other borrowers. Once the actual losses from defaulted loans are determined, they are written off against earnings. Carrying a significant amount of NPAs on the balance sheet over a period of time is an indicator to regulators that the financial health of the bank is at risk.

Types of Non-Performing Assets (NPA)

Although the most common nonperforming assets are term loans, there are other forms of nonperforming assets as well.

  • Overdraft and cash credit (OD/CC) accounts left out-of-order for more than 90 days
  • Agricultural advances whose interest or principal installment payments remain overdue for two crop/harvest seasons for short duration crops or overdue one crop season for long duration crops
  • Expected payment on any other type of account is overdue for more than 90 days

Recording Non-Performing Assets (NPA)

Banks are required to classify nonperforming assets into one of three categories according to how long the asset has been non-performing: sub-standard assets, doubtful assets, and loss assets.

A sub-standard asset is an asset classified as an NPA for less than 12 months. A doubtful asset is an asset that has been non-performing for more than 12 months. Loss assets are loans with losses identified by the bank, auditor, or inspector that need to be fully written off. They typically have an extended period of non-payment, and it can be reasonably assumed that it will not be repaid.

Special Considerations

Recovering Losses

Lenders generally have four options to recoup some or all losses resulting from nonperforming assets. When companies struggle to service their debt, lenders may take proactive steps to restructure loans to maintain cash flow and avoid classifying the loan as nonperforming altogether. When loans in default are collateralized by the borrower's assets, lenders can take possession of the collateral and sell it to cover losses.

Lenders can also convert bad loans into equity, which may appreciate to the point of full recovery of principal lost in the defaulted loan. When bonds are converted to new equity shares, the value of the original shares is usually eliminated. As a last resort, banks can sell bad debts at steep discounts to companies that specialize in loan collections. Lenders typically sell defaulted loans that are unsecured or when other methods of recovery are deemed to not be cost-effective.